Feb. 10 (Bloomberg) -- The government’s deal with banks
over their foreclosure practices after 16 months of
investigations is cheap for the loan servicers while costly for
bond investors including pension funds, according to Pacific
Investment Management Co.’s Scott Simon.

In what the U.S. called the largest federal-state civil
settlement in the nation’s history, five banks including Bank of
America Corp. and JPMorgan Chase & Co. committed $20 billion in
various forms of mortgage relief plus payments of $5 billion to
state and federal governments yesterday.

“This was a relatively cheap resolution for the banks,”
said Simon, the mortgage head at Pimco, which runs the world’s
largest bond fund. “A lot of the principal reductions would
have happened on their loans anyway, and they’re using other
people’s money to pay for a ton of this. Pension funds, 401(k)s
and mutual funds are going to pick up a lot of the load.”

Asset managers are frustrated with the deal because, in
addition to the debt the banks own, it gives credit to the
lenders for changes to loans they hold no interest in and
oversee for investors. That “treats people’s 401(k)s and
pensions,” which hold mortgage securities, “like perpetrators
as opposed to victims,” Simon said. Investment firm Angelo
Gordon & Co. said yesterday that bondholders should consider
banding together to protect their rights.

Protecting Investor Capital

The deal comes after all 50 states announced a probe into
foreclosures in 2010 following disclosures of faulty documents
used to seize homes, costing bondholders as liquidations of bad
debt were delayed.

“Think about this, you tell your kid, ‘You did something
bad, I’m going to fine you $10, but if you can steal $22 from
your mom, you can pay me with that,’” Simon said yesterday in a
telephone interview from Newport Beach, California.

Government officials say the costs will be “funded
primarily by the banks, not third-party investors,” according
to a statement posted yesterday on a website created for the
settlement. The five banks will get different amounts of credit
for various types of borrower aid, with loans in government-backed mortgage bonds exempted.

The $250 billion Pimco Total Return Fund last month was 50
percent invested in mortgage debt, typically government-backed
securities, according to its disclosures. It also owns home-loan
bonds in private funds for institutional clients.

Principal Reductions

Simon has said for more than two years that Pimco supports
the greater use of principal cuts on debt that exceeds homes’
values. It isn’t clear how often reductions for individual
borrowers sparked by yesterday’s deal will be large enough to
help, he said.

Laurie Goodman, the Amherst Securities Group LP analyst who
has advocated mortgage forgiveness in testimony to Congress,
joined him in criticizing the agreement yesterday.

“There is no one who has been more vocal in support of
principal reduction than I have been,” she said in a telephone
interview. “There is a difference between principal reductions
and giving banks credit for spending other people’s money.”

Investors have criticized servicers for allegedly basing
decisions on loan modifications on their ownership of second-lien home-equity debt, which foreclosures can wipe out. Another
allegation is that banks have hindered efforts to force
repurchases of faulty mortgages and didn’t have enough staff for
troubled loans.

Such complaints were included in a letter sent to Bank of
America in 2010 by a lawyer for a group including Pimco that
later struck a proposed $8.5 billion settlement with the lender,
which needs court approval.

Critical Questions

“All mortgage portfolio managers, large and small, should
think about their fiduciary obligations, asking critical
questions, and work together in a coordinated manner to protect
our collective investors’ capital,” said Jonathan Lieberman, a
managing director at Angelo Gordon, which manages about $22
billion of assets according to the New York-based company’s
website.

He was speaking on a conference call on the settlement held
by the Association of Mortgage Investors, according to a copy of
his remarks released by the Washington-based trade group.

Yesterday’s deal does “encourage servicers to do what they
are supposed to do” and try to work out loans, Simon said. It
will also help the housing market and provide aid to homeowners
and foreclosed-upon borrowers, with limited releases of legal
liabilities for banks, he said.

‘Big Deal’

In return, banks won’t need to completely write down their
home-equity debt before reducing mortgages, a “big deal for
them” that “makes it incredibly difficult for the private
market to develop,” Simon said.

After the worst housing slump since the 1930s, the
government is helping to finance about 90 percent of new loans,
according to newsletter Inside Mortgage Finance.

“Property rights and contract law once again take a
beating,” Simon said. “It ultimately means the private market
will take longer to develop and credit will be less available.
You’ll need bigger down payments and higher rates. That’s the
problem you won’t see for a while. Investors won’t get tricked
again.”

U.S. Housing Secretary Shaun Donovan told reporters
yesterday that “a relatively small share, in the range of 15
percent, of the principal reduction” resulting from the
settlement will come from investor-owned loans.

‘Moral Hazard’

“Nothing in it requires any trustee or servicer to reduce
principal where it’s not allowed legally by the underlying
documents,” Donovan said. “The misunderstanding somehow that
investors will be paying the banks’ share is just false.”

While officials said servicers will only rework mortgages
when it is in bondholders’ best interest, banks are now
“doubly” incentivized, by the deal and their second-lien
holdings, to skew such calculations, Goodman said.

Insufficient penalties imposed on banks for breaking rules
may fail to prevent that from happening again, Simon said.

“There’s a moral hazard element here,” he said. “This
settlement makes that potentially more likely to occur, not
less.”